Accounting 2200H Ch. 7

equation cont.

-BI and P are considered fixed because we know what those amounts are -we know how much inventory we had at the end of last year and we know what we paid for inventory in the current year -companies typically don't know the cost of every single item of inventory sold over the course of the year because companies tend to purchase inventory over time at different prices and don't track every item individually -big question is the amount that is allocated between COGS and EI

if prices are falling AND no lifo liquidation occurs

-COGS(lifo)<COGS(fifo) -reserve is decreasing (change<0)

in periods of rising prices and no LIFO liquidations

-COGS(lifo)>COGS(fifo) -change in reserve>0 -reserve is increasing

inventory turnover ratio

-COGS/average inventory -similar to receivables, inventory is an unproductive asset (it earns no interest) -this ratio measures the number of times inventory is sold during the year -in general, the higher the number, the better (under a true "just-in-time" inventory system, this ratio will approach infinity) -too high an inventory turnover may also be bad news as it suggests a greater likelihood of experiencing stock-outs and potential lost sales

LIFO

-EI consists of oldest purchases -EI on balance sheet reflects mostly older costs -COGS on income statement reflects current costs -provides a poor measure of the current value of EI but a better measure of COGS based on current costs

notes

-all four cost flow methods are allowed by GAAP even though they may have widely varying impacts on net income -but the same inventory cost flow assumption has to be used in financial reporting and tax returns (conformity rule) -seems that mangers can influence their reported income by their choice of accounting methods and they do. however, companies can't frequently switch from one method to another, depending on the desired impact they wanted on net income, because the change must be approved by the IRS

weighted average

-compute the weighted average cost of the goods you have on hand and apply this average unit cost to get the cost of goods sold -weighted average unit cost x # of units sold -all beginning inventory x price -then for purchases -sum it up

inventory

-consists of any tangible good owned by the company that is held for sale to customers (resale) or is used to produce goods or services (raw materials, work-i-progress, finished goods) -affects inventory on balance sheet and COGS on income statement

FIFO

-ending inventory consists of most recent purchases -ending inventory on the balance sheet reflects most current costs -COGS on income statement reflects older costs -provides a better measure of the current value of EI but a poor measure of COGS based on current costs

lower of cost or net realizable value (sales price less cost to sell)

-exception to the historical cost principle -if the net realizable value of our inventory units falls below cost, we need to adjust the value of inventory down -we do not want to overstate our inventory (conservatism) -an increase in net realizable value will not get reflected until we actually sell the inventory -journal entry would decrease inventory and record a corresponding expense (COGS or special items)

footnote disclosure of lifo reserve

-most footnote disclosures provide valuable information that will allow conversion between inventory methods -companies that use lifo are required to disclose in the footnotes the difference between the amount of their lifo inventory and the current value of their inventory (essentially fifo inventory)

cost flow assumptions

-not intended to reflect the physical flow of the goods -consistent method of charging the cost of goods sold to the income statement (what goes to COGS vs. what goes to inventory) -companies can use different methods for different inventories -weight average cost: weighted average not simple average

LIFO liquidations

-occurs when a LIFO company sells more units than it purchases consequences: -old LIFO layers built up in the past are liquidated -costs of items from beginning inventory are assigned to COGS -current sales prices matched against old costs distorts (yields unrealistically high) gross profit, net income, and related ratios -advantages of having updated COGS disappear -substantial tax payments -unintentional LIFO liquidation may occur due to suppliers strike or other disturbances in supply and unanticipated demand -intentional LIFO liquidation may occur in an attempt to pad income: in periodic LIFO, delaying purchases may lead to liquidation of old layers; LIFO may be used to manipulate income

consequences of lifo liquidation

-old lifo layers built up in the past are liquidated -costs of items from beginning inventory are assigned to cost of goods sold -current sales price matched against old costs -distorts (yields unrealistically high) gross profit, net income, and related ratios -advantages of having updated COGS disappear -substantial tax payments

LIFO (last-in first-out)

-the assumption is that the most recent goods are the ones that you sell first -units purchased last will go into COGS first

FIFO (first-in first-out)

-the assumption is that you sell first the oldest goods you have (regardless if this is actually how you operate or not) -out into sales or COGS, not staying in the ending inventory

lifo reserve

-the excess of fifo over lifo lifo reserve=fifo inventory-lifo inventory -can be computed/disclosed in the notes to financial statements both of the beginnings and ends of the fiscal period

specific identification method

-you identify specifically from which batch the item that was sold came from and the actual price paid (use this as the cost) -advantage- specific, we know exactly what time was sold -downside- expensive, have to keep track of every specific product, not always worth it to spend all that time -convenient only for large and expensive inventory items and customized items

COGS fifo

COGs fifo=COGS lifo - change in lifo reserves

inventory equation

beginning inventory + purchases- COGS = ending inventory (COGS + end inventory) = cost of goods available for sale

the lifo reserve reflects the

difference between current replacement prices and old prices multiplied by the number of units in inventory

cost flow assumption

does not need to follow the actual physical flow of items from the inventory because there are too many items to identify separately

ending inventory fifo

ending inventor lifo + lifo reserve end

impact on financial ratios (assuming increasing prices)

ending inventory fifo>ending inventory lifo COGS fifo<COGS lifo net income fifo>net income lifo profitability: gross profit margin [(sales-COGS)/sales] fifo>lifo liquidity:current ratio (current assets/current liabilities) fifo>lifo activity: inventory turnover (COGS/avg. inventory) fifo<lifo solvency: debt to equity ratio (total liabilities/total SE) fifo<lifo

assuming increasing prices

ending inventory: FIFO>LIFO COGS: FIFO<LIFO pre-tax income: FIFO>LIFO income tax: FIFO>LIFO net income: FIFO>LIFO

fifo and lifo allocate profits differently across periods

if all inventory is sold, then the sum of all profits from the time we purchased the inventory until the time we sold it will be equal regardless of the methods we use

importance of converting lifo to fifo

international financial reporting standards (IFRS) does not allow firms to use the lifo method of valuing inventory; anytime we compare US firm to non US firm, we have to convert US firm's financial statements to fifo

when lifo and fifo inventory are different

leads to distortions when comparing firms that use different inventory methods

lifo liquidation

occurs when a lifo company sells more units than it purchases (from beginning inventory)

two approaches to inventory record keeping

perpetual system -keeps a running balance of inventories -tracks inventories and cost of goods sold on a day-to-day basis -debt COGS expense each time a sale is made -BI+P-withdrawals=EI periodic system -does not keep a running balance of inventories -COGS and inventory updated when a physical inventory count is taken -debit COGS expense at the end of the period -BI+P-EI=COGS

formulas

sales revenue-COGS= gross profit gross profit-other expenses=pretax income (loss) BI+P=available for sale BI+P=COGS+EI